Tata Steel's acquisition of Corus rests on the hope that the boom in the global steel industry will continue.
TATA STEEL's acquisition of Corus is among the biggest acquisitions in the global steel business in the past decade. The biggest of them all, of course, was the acquisition of Arcelor Steel by Mittal Steel earlier this year. Arcelor-Mittal now possesses the largest steel production capacity in the world. Tata Steel's move is regarded as the brave Indian response to the hectic pace at which the industry is undergoing consolidation. What is driving this rush towards consolidation? And how does the Tata response shape up in that context?
There are two views of the future of the global steel industry. The optimistic camp believes that global steel production, which grew at about 6 per cent per annum between 2000 and 2005, will stay on this path for the next 20 years. This camp sees occasional downturns as aberrations rather than symptoms of any structural malady. According to this view, producers need to scale up capacities and gain control over resources such as iron ore and other raw materials in order to meet the growing demand from China, India, Brazil and other developing countries. This viewpoint requires producers to stabilise their supply lines because it forecasts that the momentum of high demand will continue to drive the industry over the next two decades.
The other viewpoint is anchored in an understanding of the history of the steel industry. In this perspective, the current boom is understood as different from the biggest boom in history, that of the 1950s and 1960s, when the steel industry was driven by the post-War boom in the developed world. This camp points out that the current boom is being led by growth in the developing world, particularly China, India and Brazil. Indeed, the China factor is huge and gives the impression that the boom has a broader basis than it actually has. In 2005, China produced 349 million tonnes of crude steel, accounting for almost one-third of the global steel output. Even this was not enough to feed the country's appetite for growth. It was the biggest importer of steel and the sixth biggest exporter of steel in the world; in 2005, its net imports amounted to 12 million tonnes and its consumption of steel also amounted to a little less than one-third of the world consumption. China is clearly the engine that has driven steel consumption in the Asian region. Its consumption, as a percentage of the total consumption in Asia, increased from 41 per cent in 1999 to 57 per cent in 2005. Steel prices, primarily buoyed by the Chinese boom, hit their peak between 2002 and 2004. This ensured high profits from investments in steel.
The conservative viewpoint believes this pace of growth cannot be sustained for more than 10 years, of which five have already passed. Therefore, those subscribing to this viewpoint calculate that by 2011-12 the industry will enter a period of crisis of overproduction, very similar to what happened in the 1970s.
Despite the moves towards consolidation, steel capacities are still fragmented. The gap between Mittal-Arcelor and Nippon Steel, the second biggest producer, highlights this. Nippon produced 32 million tonnes of steel in 2005 - less than one-third that of the industry leader. More significantly, although the Tata-Corus combine will be placed at number five in the global steel pecking order, its capacity would still not be very far ahead of most companies in the top 15. This implies that under the threat of further consolidation the Tatas may well come under pressure to acquire more capacities from rivals or expose themselves to attack from aggressive bidders.
The point about consolidation is that it is only happening at the top. The top 10 companies produce about 25 per cent of the global steel output. The rest of the steel - about 75 per cent of the global capacity - is still widely dispersed over 62 countries around the world, in plants with much smaller capacities. Industry sources say that consolidation needs to happen at the bottom end of the steel market. "The smaller producers, rather than the bigger ones, affect the market more," said a senior official in the Ministry of Steel and Mines. "The pressure building up at the bottom can result in the bigger producers losing control of the market suddenly and quickly."
Outright buyouts are only one facet of the move towards consolidation. Alliances between big players have also been formed to enhance pricing power in the market. Arcelor, for instance, entered into an alliance with Nippon to supply steel for the automobile industry across the world.
Even if the top five to ten producers form a cartel and fix prices high, smaller producers can, thanks to the fragmented structure of the industry, enjoy a free ride by being able to charge higher prices. This would result in a heavy build-up of capacities because even small producers would find these price levels attractive. Since the latter's fixed costs are lower than those of the bigger players, they would find the situation even more comfortable. Of course, this situation cannot be sustained indefinitely. As capacity utilisations fall, there would be a scramble at the bottom of the market to undercut prices in order to stay afloat. And, when that happens, the market will collapse as the smaller players, who are offering lower prices, exit.
This is exactly what is happening in China. Chinese steel prices are about $420 a tonne, compared with world export prices of about $500-530. But this price differential cannot be maintained indefinitely. The bigger players are now defending price levels by effecting production cutbacks. But if the pressure keeps building, the bigger producers will also have to lower prices on top of effecting production cuts. They will therefore lose out on both price and volume. When they start losing on both fronts, they will be in deep trouble. Profitability is already under pressure because of the rising costs of raw materials, particularly iron ore.
The steel cycle is still on the up but supply pressures are building up quickly. The conservative camp expects the downturn to start in 2007. Prices are already under pressure and there is also a build-up of inventory. The year 2007 could be a bad one for the industry and the downturn could be a prolonged one.
If there is a downturn, steel producers in the developed world will be in worse trouble. An industry source remarked, "Corus may have thought about such a situation when it decided to sell out to the Tatas. The fact that the Tatas will be acquiring a high-cost producer as the industry approaches a downturn does not look very good."
The optimistic camp regards every fall in the market as a temporary aberration; and it sees the boom as endless. It was this kind of euphoria that created huge excess capacities in the 1970s and 1980s. Market sentiments, it appears, are playing a crucial role in forecasts for the future.
Once profits fall to more "normal" levels, the industry may well undergo a period of aggressive consolidation, resulting in the weeding out of smaller-capacity producers and a fresh wave of acquisitions. This kind of consolidation has already happened in the iron ore trade, where three companies control 80 per cent of the international trade.
According to one forecast presented recently at a conference on the global steel industry in Delhi, 25 years hence five companies will control half the world's steel production. At that time, the largest company is expected to have a capacity that would be about three times that of today's industry leader by far, Mittal-Arcelor.
Placed in this context, it is obvious that Tata Steel's acquisition of Corus represents only a small first step into the global steel order. Only time will tell whether it is able to protect its turf while expanding operations in a hostile environment.